Case study

Nike Inc. Cost of Capital

NorthPoint
• Representing NorthPoint we are looking forward to invest in the most
successful way as possible, having in mind the historical background the
firm has.

• A history of successful value investing, with holdings including

ExxonMobil, General Motors, McDonald’s and many others, searching for
stocks that are trading for less than their intrinsic value.

• Even if the stock market is declining in the last 18 months, the Fund was
highly successful and we are looking forward to follow this path.

• Now we’re looking for new opportunities in the market and we feel that Nike
Inc. could be what we’re searching for.
Why 
Nike declines in sales 
Targets Market response
Nike?  growth, profits and  Strategic plan
market and share.

Stagnating revenue of $9 billion  Increasing exposure in mid‐ Revenue growth from 8% to  Analysts had mixed reactions 

from 1997 – 2001. price footwear and apparel  10%. of being either setting 
lines. aggressive financial targets or 
Sales growth decline in income  Earning growth above 15%. had significant growth 
from almost $800 million to $580  Intends on cutting down  opportunities within apparel 
million. expenses. and the international 
businesses. 
Market share had fallen from 48% 
in 1997 to 42% in 2000. The Lehman Brothers propose 
a “buy” while the UBS Warburg 
Recent supply chain issues and  and CFSB suggested a “hold”
adverse effect of a strong dollar had 
a negative effect on revenue
Case summary
Kimi Ford, a portfolio manager at NorthPoint Group is seeking to invest in shares of 
Nike. She asked her assistant Joanna Cohen to estimate the cost of capital for Nike.
Cost of Debt
Joanna’s memo:

Wrong!

The reasons:
‐ interest charges are not applied to all debts；
‐ the calculation is based on historical data of 2001 
which cannot reflect Nike’s current or future cash flow.
 Cost of Debt
Current Price $ 95.6  PV = 95.6
Par value $ 100  F = 100
Coupon Rate 6.75%  Coupon C = 6.75% x 100 / 2 = 3.375 
Coupon payment Semi-annual
Maturity 20 years  T = 20 x 2 = 40
0 1 2 3 ……… T

C              C C C + F

1 1 𝐹
𝑃𝑉 𝐶 1
𝑟 1 𝑟 1 𝑟
Annuity Discount Factor (r,T)
 Use rate function in Excel:  =RATE(40,3.375,‐95.6,100) = 3.58% (semiannual) 

rd = YTM = 3.58% x 2 = 7.16%
 Cost of Equity
The return a firm pays to its equity investors such as shareholders

Capital Asset Pricing  Dividend Discount Model Earnings Capitalisation Method

Model (CAPM) (DDM) (ECM)

Assumptions Assumptions
Assumptions •Long operating cycle •Steady state
• Risk‐free security •Constant dividend growth •Future earnings is 
• Beta is stable over time •Pays dividend dependent on past earnings
• Most widely used •Steady state
• Relationship between risk  CASH COW •Uses the relationship 
(risk‐free rate) and the  between earnings next year 
premium  •Uses the relationship  and current stock price
• Systematic risk between dividend price, 
current stock price, dividend  Merit
Merit growth rate •Very simple
• Only considers systematic  Merit •Useful when assumptions 
risks  •Accurate if assumptions hold are met
Drawback Drawback
• Components are rough  •If assumptions are violated,  Drawback
estimates  can’t be used •Projected earning may be 
•Constant dividend growth wrong 
Capital Asset Pricing Model (CAPM)
where RF is risk-free rate, β is beta, (RM – RF) is market risk premium
Capital Asset Pricing Model (CAPM)
where RF is risk-free rate, β is beta, (RM – RF) is market risk premium

• 10 Year  VS  20 Year Treasury Bond
Joanna • For more mature firms and it matches the 
duration of Nike’s future cash flow 
Risk‐free rate
5.74% projection (02’‐11’)
20 Year Treasury bond

Risk premium
• Geometric  VS  Arithmetic mean 
Geometric mean of ERP
5.90% • Future performance is dependent on past 
performance
Average of betas
0.8017
From 1996 to 2001 • Average beta, Latest beta, or Adjusted‐beta?
Re-estimation

• re = 5.39% + 0.69 x 5.90% =  9.46%
Risk‐free rate
5.39%
10 Year Treasury bond
vs 10.50% by Joanna
Market Risk premium
5.90%
Geometric mean of ERP

Beta 0.69
DDM & ECM
Dividend Discount Model Earnings Capitalisation Method
(DDM) (ECM)

where E1 is earnings next year, P0 is current stock price 
where D1 is dividend price, P0 is current stock 
price, g is dividend growth rate
$ 2.32
$ 0.48
$ 42.09
$ 0.48 (1 + 5.50%)

$ 42.09

5.50%

Remember: Nike’s cost of debt

from our previous calculation is
7.16%
Which method is the best?
• DDM & ECM
▫ Comparing the values we gained using DDM and ECM to 
cost of debt (7.16%); the values are significantly lower
 Usually re > rd
 Shareholders are more exposed to risks as they invest in the 
company > expect higher return
▫ Nike still has high growth opportunity  Violate the
▫ Competitors exist; Nike is not in a steady state assumptions

DDM and ECM are not appropriate
 Debt and equity weights

Nike’s Balance Sheet

 Debt and equity weights
• Joanna uses the book value of equity instead of market.

Capital Sources Market value (in millions,$)

Debt

Current portion of long-term debt 5.4

Notes payable 855.3

Long-term debt 435.9

$ 1,296.6

Equity = Current share price  x  Number of Outstanding Shares

Equity = $42.09 x 271.5 = $11,427.435
 Debt and equity weights

WACC = 9.46% x 0.8981 + 7.16% (1-38%) 0.1019 = 8.95%

vs. Joanna’s WACC = 8.4%

 Single cost vs Multiple costs

• Nike has numerous divisions of business.

▫ Cole Haan – different products (4.5% revenue)

• We agree with Joanna that using the single cost of capital seems to be
more appropriate.
▫ The reason of estimating WACC in this case is to value the cash flows for the
entire firm;
▫ Nike’s business segments of Nike basically have about the same risk.
Takeaway
• Joanna made the following mistakes:
▫ Not using YTM for publicly traded debts
▫ Not using the current beta
▫ Not being consistent in matching horizon for the risk free return and
forecast horizon
▫ Using book value weight instead of market for equity